13DIVIDEND CHAPTER POLICY
TRUE/FALSE
1. The dividend irrelevance theory, proposed by Miller and Modigliani, says that as long as a firm pays a dividend, how much it pays does not affect either its cost of capital or its stock price. ANS: F DIF: Easy TOP: Dividend irrelevance
2. The farther to the right the IOS is, other things held constant, the lower a firm's dividend payout ratio. ANS: T DIF: Easy TOP: IOS and dividend payout
3. A reverse split reduces the number of shares outstanding. ANS: T DIF: Easy TOP: Reverse split
4. The dividend irrelevance theory says that the firm's dividend policy has no effect on either its value or its cost of capital. ANS: T DIF: Easy TOP: Dividend irrelevance
5. Managers, on average, do not raise dividends unless they believe future earnings will be able to sustain the higher level dividends. ANS: T DIF: Easy TOP: Signaling hypothesis
6. According to the free cash flow hypothesis, cash flows that cannot be reinvested in positive net present value projects should be kept as retained earnings. ANS: F DIF: Easy TOP: Free cash flow hypothesis
7. Firms following a constant dividend ration payout policy will cause investors to have greater uncertainty concerning expected dividends each year when the earnings for the firm are stable over time. ANS: F DIF: Easy TOP: Constant payout ratio
8. The "new stock" type of dividend reinvestment plan allows the stockholder to automatically reinvest dividends to buy existing in the open market. ANS: F DIF: Easy TOP: Payment procedures
9. The ex-dividend date is the date on which a firm actually mails dividend checks. ANS: F DIF: Easy TOP: Payment procedures
10. Firms with a large number of acceptable capital budgeting projects generally have a high dividend payout ratio. ANS: F DIF: Easy TOP: Dividend policy factors
11. A stock split is always associated with an increase in the value of the equity outstanding. ANS: F DIF: Easy TOP: Stock split
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12. On a 2-for-1 stock split, the shares outstanding are doubled, and the stock's par value is halved. ANS: T DIF: Easy TOP: Stock split
13. The dividend payout ratio, on average, for companies in the United States is higher than for companies in Japan. ANS: F DIF: Easy TOP: Dividend policies around the world
14. A firm that follows a residual dividend policy must believe that the dividend irrelevance theory is correct. ANS: F DIF: Medium TOP: Dividend irrelevance
15. If the shape of the curve depicting a firm's WACC versus its debt ratio is more like a sharp "V", as opposed to a shallow "U", the easier it will be for the firm to maintain a steady dividend in the face of varying investment opportunities from year to year. ANS: F DIF: Medium TOP: WACC and dividend policy
16. If the information content, or signaling, hypothesis is correct, then changes in dividend policy can be important with respect to firm value and capital costs. ANS: T DIF: Medium TOP: Signaling hypothesis
MULTIPLE CHOICE
1. In the real world, we find that dividends a. Usually exhibit greater stability than earnings. b. Fluctuate more widely than earnings. c. Tend to be a lower percentage of earnings for mature firms. d. Are usually changed every year to reflect earnings changes. e. Are usually set as a fixed percentage of earnings. ANS: A DIF: Easy TOP: Dividend payout OBJ: TYPE: Conceptual
2. Which of the following would not have an influence on the optimal dividend policy? a. The possibility of accelerating or delaying investment projects. b. A strong shareholders' preference for current income versus capital gains. c. Bond indenture constraints. d. The costs associated with selling new common stock. e. All of the above can have an effect on dividend policy. ANS: E DIF: Easy TOP: Optimal dividend policy OBJ: TYPE: Conceptual
3. We can be sure that, in and of itself, a stock dividend will not affect which of the following financial aspects of the firm? (Assume the stock has a par value.) a. Market value per share. b. Book value per share. c. Common stock account . d. Paid-in capital account. e. Total assets. ANS: E DIF: Easy OBJ: TYPE: Conceptual TOP: Stock dividends
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4. Those who believe investors choose a particular stock due to the firm's dividend policy would contend that firm should consider the __________ effect when changing dividend policies. a. clientele b. tax c. free cash flow d. IRS e. relevance ANS: A DIF: Easy TOP: Clientele effect OBJ: TYPE: Conceptual
5. The residual dividend policy implies that investors prefer to have the firm retain and reinvest earnings rather than pay them out in dividends if the rate of return the firm can earn on reinvested earnings a. exceeds the cost retained earnings. b. is less than the WACC. c. exceeds the cost of debt. d. exceeds the rate average investors can earn themselves for other investments of similar risk. e. is less than the rate average investors can earn themselves for other investments of similar risk. ANS: D DIF: Easy TOP: Residual dividend model OBJ: TYPE: Conceptual
6. The ex dividend date is __________ prior to the holder-of-record date. a. one business day b. two business days c. five business days d. one week e. one month ANS: B DIF: Easy TOP: Payment procedures OBJ: TYPE: Conceptual
7. The date on which a firm's board of directors issues a statement declaring a dividend is the __________. a. declaration date b. holder-of-record date c. ex-dividend date d. payment date e. conversion date ANS: A DIF: Easy TOP: Payment procedures OBJ: TYPE: Conceptual
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8. Why is the ex-dividend date important to someone who is considering purchasing a firm's stock? a. If the stock is purchased on this date or later the buyer will not receive the next dividend paid by the firm. b. This is the date the firm "opens its books" to determine the names of the persons who will receive the next dividend that will be paid. c. This is the date the board of directors announces the value of the next dividend payment, so the market price of the stock will increase at this point. d. This is the date the dividend is paidthat is, dividend checks are mailed to investors. e. The ex-dividend date really isn't very important to potential investors; this date is more important to accountants who construct financial statements because it is the date the dividend becomes a legal liability of the firm. ANS: A DIF: Easy TOP: Payment procedures OBJ: TYPE: Conceptual
9. If you are considering purchasing a stock because you want to receive the next dividend that will be paid by the firm, which of the following dates would be most important to the timing of your purchase? a. declaration date b. ex-dividend date c. payment date d. the date the firm's fiscal year ends e. holder-of-record date ANS: B DIF: Easy TOP: Payment procedures OBJ: TYPE: Conceptual
10. According to your text, the ex-dividend date associated with a stock is two days before the a. declaration date. b. holder-of-record date. c. payment date. d. firm pays interest on its debt every year. e. None of the above answers is correct. ANS: B DIF: Easy TOP: Payment procedures OBJ: TYPE: Conceptual
11. Which of the following influences dividend policy? a. constraints on dividend payments such as debt contract restrictions b. investment opportunities c. alternative sources of capital d. cash availability e. all of these exert an influence on dividend policy. ANS: E DIF: Easy TOP: Dividend policy factors OBJ: TYPE: Conceptual
12. All else equal, a "normal" stock split a. generally results in a significant increase in the per share price of the stock from what it was before the split. b. reduces the number of shares of stock outstanding. c. increases the number of shares of stock outstanding. d. does not need to be recognized in any way on the balance sheet of a corporation. e. increase the dividend per share. ANS: C DIF: Easy OBJ: TYPE: Conceptual TOP: Stock dividends and splits
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13. A 2-for-1 stock split a. increases the number of shares of stock held by the firm's stockholders. b. increases the per share price of the firm's stock. c. requires stockholders to invest more money in the firm's stock. d. requires the firm to adjust the value of its total assets on the balance sheet. e. generally decreases the total value of the firm that splits its stock. ANS: A DIF: Easy OBJ: TYPE: Conceptual TOP: Stock dividends
14. The portion of the firm's earnings that been has reinvested in the firm rather than paid out in dividends is called a. net income. b. gross margin. c. reinvestment return. d. retained earnings. e. DRIP. ANS: D DIF: Easy TOP: Dividend payout OBJ: TYPE: Conceptual
15. If the Modigliani and Miller hypothesis about dividends is correct, and if one found a group of companies which differed only with respect to dividend policy, which of the following statements would be most correct? a. The residual dividend model should not be used, because it is inconsistent with the MM dividend hypothesis. b. The total expected return, which in equilibrium is also equal to the required return, would be higher for those companies with lower payout ratios because of the greater risk associated with capital gains versus dividends. c. If the expected total return of each of the sample companies were divided into a dividend yield and a growth rate, and then a scatter diagram (or regression) analysis were undertaken, then the slope of the regression line (or b in the equation /P0 = a + b(g)) would be equal to +1.0. d. None of the above statements is true. e. All of the above statements are true. ANS: D DIF: Medium TOP: MM dividend theory OBJ: TYPE: Conceptual
16. Which of the following statement completions is correct? If investors prefer dividends to capital gains, then a. The equilibrium return, ks, will not be affected by a change in dividend policy because tax effects will offset these preferences. b. ks will decrease as dividends are reduced. c. ks will increase as dividends are reduced. d. ks will decrease as the retention rate increases. e. Dividend policy as determined by the residual dividend model is the only dividend policy which will maximize the price per share of common stock. ANS: C DIF: Medium TOP: Dividends versus capital gains OBJ: TYPE: Conceptual
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17. Firms following a constant payout ratio dividend policy a. will have a stable dividend payment when earnings fluctuate. b. will have a fluctuating dividend policy when earnings are stable. c. will have a higher cost of equity when earnings are stable compared to other similar firms. d. will have a lower cost of equity when earnings are stable compared to other similar firms. e. will have a fluctuating dividend payment when earnings fluctuate. ANS: E DIF: Medium TOP: Constant payout ratio OBJ: TYPE: Conceptual
18. For the past 10 years, Green Thumb Shrubbery has paid a very handsome dividend such that the dividend yield normally has been approximately 10 percent. The holder-of-record date for the next dividend payment is tomorrow. Sally Anderson just bought Green Thumb's stock a few minutes ago. As a result and assuming the stock's price has been stable for the past couple of days, the price Sally paid for her stock should have been a. greater than it was a couple of days ago because she will get the next dividend paid by Green Thumb, which is expected to be fairly substantial. b. less than it was couple of days ago because she will not receive the next dividend paid by the company. c. approximately the same as it was a couple of days ago because the stock's price has been stable and the next dividend should not affect the current price of the stock. d. differ from what it was a couple of days ago because the prices of all stocks constantly fluctuate; but there is not enough information to determine whether the price will be higher or lower than it was previously. e. None of the above is a correct answer. ANS: B The ex dividend date is two days prior to the holder of record date, therefore Sally Anderson will not receive the dividend. DIF: Medium OBJ: TYPE: Conceptual TOP: Payment procedures
19. Assume that stockholders have exactly the same information as the managers who make the financial decisions of the firm. If the managers always make rational investment decisionsthat is, they purchase only positive net present value capital budgeting projectswhich of the following dividend policies should investors prefer the managers follow? Consider everything else is equal. a. residual dividend b. constant payout ratio c. stable, predictable dividend d. low regular dividend plus extras e. It shouldn't matter which dividend policy the managers follow because each policy should maximize the value of the firm. ANS: A DIF: Medium TOP: Optimal dividend policy OBJ: TYPE: Conceptual
20. The study by Rafeal La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishney identify all the following factors as explanations for dividend policy difference around the world. a. measures that help protect the minority right of shareholders. b. growth opportunities. c. risk associated with expected future dividends. d. number of shares outstanding. e. all of the above influence dividend policy differences around the world.
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ANS: D DIF: Medium OBJ: TYPE: Conceptual TOP: Dividend policies around the world 21. Ducheyne Electric recently declared a 15 percent stock dividend. On the date of the stock dividend Ducheyne had 16 million shares outstanding priced at $46 per share in the market. An accounting entry was required on the balance sheet transferring some retained earnings to the common stock account. If retained earnings was $280 million prior to the transaction, what was the dollar amount of retained earnings after the transfer? a. $280.0 million b. $110.4 million c. $234.0 million d. $277.6 million e. $169.6 million ANS: E Amount of transfer: 16,000,000 shares 0.15 $46.00 = $ 110,400,000. Before stock dividend: RE = Less: transfer RE after transfer DIF: Easy OBJ: TYPE: Problem $280.0 million (110.4 million) $169.6 million TOP: Stock dividends
22. The following facts apply to your company: Target capital structure: 50% debt; 50% equity. EBIT: $200 million. Assets: $500 million. Tax rate: 40%. Cost of new and old debt: 8%. Based on the residual dividend policy, the payout ratio is 60 percent. How large (in millions of dollars) will the capital budget be? a. $43.2 b. $50.0 c. $64.8 d. $86.4 e. $108.0 ANS: D We are dealing with a situation like this:
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Debt = 0.5(Assets) = 0.5 ($500) = $250 million. Interest = 0.08($250) = $20 million. EBT NI = EBIT - I = $200 - $20 = $180. = $180 - Taxes = $180 - $180(0.4) = 0.6($180) = $180 million.
Dividends = $108(0.6) = $64.80 million. Retained earnings = NI - D = $108.00 - $64.80 = $43.20 million. Half of the capital budget will be debt. Half common equity from retained earnings, so the capital budget will be: Capital budget = DIF: Medium = $86.40 million. OBJ: TYPE: Problem TOP: Residual dividend and capital budget
23. Flavortech Inc. expects EBIT of $2,000,000 for the coming year. The firm's capital structure consists of 40 percent debt and 60 percent equity, and its marginal tax rate is 40 percent. The cost of equity is 14 percent, and the company pays a 10 percent rate on its $5,000,000 of long-term debt. One million shares of common stock are outstanding. In its next capital budgeting cycle, the firm expects to fund one large positive NPV project costing $1,200,000, and it will fund this project in accordance with its target capital structure. If the firm follows a residual dividend policy and has no other projects, what is its expected dividend payout ratio? a. 100% b. 60% c. 40% d. 20% e. 0% ANS: D Dividend payout ratio EBIT Interest EBT Taxes NI Project funding Residual earnings payable as dividends $2,000,000 (500,000) $1,500,000 (600,000) $ 900,000 (720,000) $ 180,000 ($5,000,000 10%) ($1,500,000 40%)
Dividend payout ratio = $180,000/$900,000 = 20%. DIF: Medium OBJ: TYPE: Problem TOP: Dividend payout ration
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24. Makeover Inc. believes that at its current stock price of $16.00 the firm is undervalued in the market. Makeover plans to repurchase 2.4 million of its 20 million shares outstanding. The firm's managers expect that they can repurchase the entire 2.4 million shares at the expected equilibrium price after repurchase. The firm's current earnings are $44 million. If management's assumptions hold, what is the expected market price after repurchase? a. $16.00 b. $17.26 c. $18.18 d. $20.00 e. $24.40 ANS: C Step 1: Current EPS = $44 million/20 million = $2.20 per share. Step 2: Step 3: Step 4: P/E ratio = $16.00/$2.20 = 7.27x. EPS after repurchase = $44 million/17.6 million = $2.50. Expected market price after repurchase: 7.27 $2.50 = $18.175 = $18.18 per share. DIF: Medium OBJ: TYPE: Problem TOP: Stock repurchase